Minute in the Market: Muni Credit - A Look Back and a Look Ahead

Having recently completed the financial review of our municipal holdings for the latest fiscal year, we thought it would be appropriate to share our thoughts on the state of the municipal credit market. Generally, we are pleased with what we saw and are maintaining a constructive outlook on the sector. Most municipalities have been able to dig out of the recession-driven balance sheet stress that plagued them for much of the decade and have emerged with healthy and, in some cases, quite strong financial positions. Of course, there are certain idiosyncratic situations that don’t fit the mold, but for the most part, things are looking up. We have organized our thoughts on a sector level by focusing on credit trends and outlooks. In an attempt to get straight to the point, we are using notes as opposed to long-form prose. Please contact us with any questions, but we hope this piece provides both comfort that we have a handle on the situation and confidence that we’ll be able to spot relative value and any change in trend if one should occur.
State revenues continued to increase, but at a slower rate than in previous years. States also continued to defer maintenance and otherwise underspend on infrastructure, and they have so far failed to address growing unfunded liabilities for pensions and OPEBs.

The U.S. Economy’s continued recovery has benefited most states. The economies of some states have also been aided by more localized developments, such as the tech boom in California and the oil boom in Colorado, North Dakota and Texas.

Outlook 2015
Continued economic expansion, job growth, and lower fuel costs will boost income tax and sales tax revenues, but increases in transfers to local governments will consume most of the revenue gains. The current oil bust, if it continues, will hit producers (ND, CO) harder than refiners, processors and petrochemicals (TX).

Transfer payments will grow towards pre-recession levels and perhaps beyond (in nominal terms).
The tech boom will continue, though the continuation of the oil boom/bust is uncertain.
Local Municipalities and K-12
Taxable values continue to grow, with some areas exceeding 2007/08 highs (for example the San Francisco Bay Area), but most metro areas are still below highs, but only slightly.
State support has been slow to materialize, but well managed, economically diverse and positive demographic areas saw improvement (Dallas/Fort Worth, TX).
Bankruptcy proceedings in Detroit and Stockton treated pensioners far more generously than bondholders. Bankruptcy has become a viable option for local muni credits to shed liabilities. 2014 represented a watershed year for GO municipal credit defaults.
Outlook 2015
“This isn’t your Daddy’s municipal bond market.” 
Bankruptcy priority is advancing pensioner interest above bondholders.
A credits’ security pledge has become less important than underlying credit fundamentals.
Assessable values will rise and exceed 2007/08 highs. Areas hit hardest by foreclosures will lag, but still see improvement.
Hospitals (not-for-profit)
Medicare/aid and the roll-out of the federal insurance mandate have reduced operating margins and spurred consolidation. Large regional players are maintaining positive operating margins. State- or city-run care centers that focus on the uninsured have benefited from increased insurance coverage.
A merger and acquisition trend is well underway, and will continue with the risk of thin to negative operating margins due to expensive organization consolidation and management missteps. An example is Swedish Health Services, now part of Providence.

Outlook 2015
Larger players and university health centers are better positioned to manage change, and generally have very strong balance sheets.
Merger/acquisitions of smaller, more remote systems into larger metro area organizations will continue, but the most compelling mergers (those most attractive in the long term) may already have occurred.
Higher Education
Lack of tuition affordability and reduced state support are placing greater pressure on income statements.
Flagship state universities continue to show impressive balance sheet strength and pricing power due to lower tuition costs relative to private institutions.
Smaller liberal arts colleges are becoming less competitive based on tuition, and declining net tuition revenue is pressuring balance sheets. Endowment pressure and risk taking are increasing as investment revenue is used to fill shortfalls in operating revenues and to fund student aid (thereby increasing affordability).
Outlook 2015
Tuition affordability will continue to weigh on the sector, and state support of public institutions is unlikely to return to pre-recession levels.
Expect credit downgrades of small private liberal arts institutions.
Endowments’ investment performance should accelerate balance sheet improvements.
Airports benefit from enplanement growth, which leads to higher passenger volumes and more ancillary fees (parking and concession fees) and Passenger Facility Charges (PFCs). The driver of enplanements is improved economic conditions. In addition, higher global wealth levels are benefiting international hubs as flying becomes an option for more people.
The sector weathered airline bankruptcies and consolidations well because landing fees and terminal leases are generally not material components of airlines’ cost structures (fuel and labor being the material components). Balance sheet ratios are trending positive, but high debt loads due to increasing demand for expansion of facilities continue to pressure debt service coverage.
In many cases, PFCs subsidize operating margins and debt service coverage, but there are no anticipated changes to the PFCs from the max rate of $4.50 per passenger. Ancillary charges represent nearly half of airport revenues in some locations.
“International” hubs maintain their strategic importance. “Origination & Departure” airports with strong local economies (SEATAC) show credit strength. Destination airports (Las Vegas) continue to improve with the overall economy.

Outlook 2015
Moody’s sees enplanements accelerating from 2% to 3% to 4% in 2015 on continued economic growth, and has upgraded the sector from stable to positive.
The airline industry has consolidated into traditional carriers (American Airlines and Delta) and discount carriers. This new dynamic has and will continue to concentrate single carrier operational risk. For example, DFW is predominately (+75%) American, and ATL is predominately Delta.
Parking revenue bonds are becoming an important source of financing for infrastructure improvements.
“Crowding skies” issues will benefit from GPS technology and force large metro airports (NYC) to specialize as domestic or international hubs.
Toll Roads & Transportation – GARVEEs
Toll road defaults were the 2014 story. Indiana Toll Road exited bankruptcy. It was privatized in 2006, but since it never realized projected pro forma revenues due to the economic downturn, the system is again up for sale. The Foothill/East Transportation Corridor in CA also restructured its debt due to limited rate-raising ability and insufficient volumes. Both of these cases demonstrate how overly optimistic vehicle travel projections and poor revenue estimates can be the downfall of a toll road credit.
NJ and PA Turnpikes continue to be a source of persistent revenue transfers for states with unbalanced budgets. However, the NJ Turnpike has significant revenue capacity (it raised tolls 50% in 2013) and ample liquidity to support the transfers.
Free cash flows can be prodigious for systems with: (1) limited competition from non-tolled freeways, (2) electronic toll payment systems and (3) conservative budget practices.
GARVEEs (Grant Anticipation Revenue Vehicles) are threatened by the Highway User Revenue Trust Fund deficit. There is little action on a replacement for the gasoline tax (last updated in the early 1990s) to support the Trust Fund. However, Congress has taken annual appropriation action to support the fund.
Outlook 2015
The outlook for 2015 is upbeat due to increased vehicle miles driven. This is a significant milestone because it represents a reversal of the recent trend.
Look for states and local authorities to lease toll roads and transportation assets as a mechanism to fund pension and OPEB liabilities.
Because Congress shows no sign of increasing funding for the Highway Trust Fund, annual last-minute appropriation “fixes” are likely to continue. States and local taxing authorities will step up to fill the funding gap with new sales or fuel taxes.
Seaports continue to benefit from improvements in the U.S. economy. The top 10 ports by volume have monster balance sheets, a sticky business model and significant pricing power. Operating margins are strong and coverage ratios are sufficient to withstand economic downturns.
Labor disputes at West Coast ports resulted in delays, but these types of labor disputes are short-term in nature and do not represent a material credit risk.
The rise of natural gas and distillate exports will offer little benefit to existing public ports since much of the oil and gas activity is handled through private facilities.
Mississippi River barge traffic is an important means of shipping commodities. Infrastructure spending is needed to maintain flood controls and navigation.
The Jones Act requires that any goods shipped by water between two U.S. ports must be on a U.S. built, owned and flagged vessel. There are no initiatives to repeal or update the Jones Act.
The cruise line industry is increasingly important (for example, Miami-Dade and Port of Baltimore), but more variable than the shipping industry.

Outlook 2015
The outlook for 2015 is the same as 2014. However, major mid-term (next 5 yrs) shifts will occur in the sector.
The future of North American (N.A.) ports will depend on the opening of the expanded Panama Canal and the location of a N.A. shipping hub post Panamax. Post Panamax ships are so large and carry so many containers that they will change how shipping is done in N.A.
Miami Dade Seaport sits in an interesting position for becoming the N.A. shipping hub post Panamax. It is the largest cruise line hub in N.A. The credit has taken on significant debt to upgrade its facility to accept larger ships. The credit offers nice risk reward characteristics because of higher yield levels relative to other ports.
Water and Waste Water
Water and wastewater utilities continue to display strong credit fundamentals. Solid balance sheets, strong revenue capacity, positive operating margins and ample coverage ratios make this sector one of the most stable in muniland.
The lesson learned from the City of Detroit bankruptcy settlement is that secured revenue debt (W/WW component unit) may be impaired despite strong operating fundamentals. The Detroit case saw W/WW bondholders lose their call protection through a tender offer that ended up reducing interest payments, but gain a pledge to repay 100% of the principle amount.
Aging infrastructure and environmental mandates (sewage overflow) is pressuring operating margins and increasing leverage ratios.
Drought conditions in the West (California) and Southeast highlight the need for new infrastructure spending on water conversation efforts as well as increased supply capacity.
Outlook 2015
Credit trends will continue in 2015.
Debt supply may receive a boost from the Qualified Public Infrastructure Bonds (QPIBs) proposal, but we will have to wait and see if the measure becomes a reality.
California ballot initiative Prop 1, the water bill, passed, which calls for $7.12B in GO debt to support water supply infrastructure projects.
Electric Utilities
Electricity generation and transmission utilities continue to display strong historical credit fundamentals. Solid balance sheets, strong revenue capacity, positive operating margins and ample coverage ratios make this sector one of the more stable in muniland.
Low cost hydro power generators maintain their strong position even in an environment where natural gas is becoming a competitive player.
Sustainable electrical producers (green bonds) are still a relatively small portion of the municipal market.

Outlook 2015
The outlook for 2015 is similar to 2014’s credit trends.

However, long-term shifts in the sector are beginning to develop. Decentralized generating capacity (photovoltaic panels) and advancements in energy storage capacity are becoming cheaper and more widely used. This is a long-term fundamental shift that will undermine the monopolistic power of centralized electricity generators. Though the trend has been developing slowly, electricity generation is a sedate industry and management may make mistakes.
Transmission utilities are positioned well for decentralized electrical generation based on photovoltaic power, natural gas and storage environment. The rise of a distributive power system and its associated pricing power is a long term positive for the sector.